September 2022 – ZA Economist

The dark side of the improved balance of payments

Brian Kantor

28^th September 2022

The Covid lockdowns has quite dramatically altered the relationships between the South African economy and its global trading and financial partners. What followed Covid was a dramatic improvement in the balance of exports and imports. After 2020 exports, helped by higher prices, grew significantly faster than imports to take the balance of trade to a mammoth, nearly 10% of GDP by Q2 2021. As export prices have fallen off more recently the trade surplus has declined to a still impressive 4.8% of GDP in Q2 2022.

The difference between exports and imports is also the difference between GDP- output or equivalently incomes – earned producing that output – and Gross Domestic Expenditure –mostly on consumption by households and partially on capital goods by firms – that can be funded with loans to supplement current incomes. The trade balance – when positive -represents an excess of local supply over local demands- a contributor to global supply chains- rather than a drawer or absorber of them. The SA economy has thus helped dampen global inflation.

The closely watched current account of the balance of payments adds foreign mostly investment income to the trade balance. South African borrowers and capital raisers pay out interest and dividends at higher rates and yields than they typically receive from their foreign investments. Even though South African’s foreign assets roughly match their foreign liabilities (thanks to Naspers and its Ten Cent investment) This force usually turns trade surpluses into current account deficits – being the sum of the trade balance and the net foreign income accounts.

By definition of the balance of payments accounting system the current account deficits (or surpluses) are equal to foreign capital inflows or outflows. Instead of drawing on global capital markets to fund its capital expenditure budgets South African savers- almost all realized by its corporations to offset very marginal surpluses of the household sector and public sector deficits, became a significant source of savings for world capital markets. Instead of drawing on global capital markets to fund capital expenditure budgets we became a significant source of savings for world capital markets- some 300 billion rands worth since Covid. The current account is now in rough balance.

The trade balance, the current account and net foreign income. South African Balance of Payments Statistics. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

Rather a lender than a borrower is conventionally good news for balance sheets and credit ratings- – provided all else remains the same. Ideally raising capital even debt – to spend on capital goods with long productive lives that earn above the cost of debt- is good for any company or government and all its dependents. It means faster growth- and faster growth is the key to attract capital – especially equity capital – on favourable risk adjusted terms. Though the influence of removing one of the SA deficits, the capital account deficit – and improving the fiscal deficit, also with the help of the exporters, has not been conspicuous in the market for rands. The exchange rate of the ZAR with the USD, as for all other currencies, is being dominated by the dollar and the actions of the US Fed.

There is a dark side to South Africa’s lesser dependence on foreign capital. The reason the SA trade balance has improved as much as it has is because the rate at which South African’s have saved since Covid disrupted incomes and output has held up much better than the rate at which the economy has added to its capital stock. The ratio of Capital Expenditure to GDP has very worryingly continued to decline – from the 20% of GDP range before 2016 to the current 14% of GDP rate. The savings rate appears to have stabilized at the 14% rate.

These capital expenditure trends portend very poorly for the economy. They imply persistently slow growth that will continue to threaten the ability of the SA government to raise revenues to fund its ambitious welfare programmes. Slow growth adds to the risk of investing in SA and the cost of raising capital from all sources domestic and foreign. It means less capital expenditure and slower growth. Ideally South Africa should be raising its capital expenditure rate and funding more of it by attracting foreign capital on favourable terms, growing faster by reducing the risk premium with appropriate actions. Current account deficits and capital inflows to fund growth would then be very welcome.

The trade balance and the difference between savings and capital expenditure. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

Savings and Capital Expenditure. Ratio to GDP. Quarterly Data

Source; SA Reserve Bank and Investec Wealth and Investment

The day the market stopped fighting the Fed

The financial market reactions to the US CPI news on 13^th September provides an extreme example of how surprising news plays out in the day-to-day movements of share prices, interest and exchange rates. The key global equity benchmark, the S&P 500 lost nearly 5% of its opening value after the announcement that inflation in August had been slightly higher than expected. Implying that the Fed that sets short term interest rates in the US would be more aggressive in its anti-inflationary resolve, making a recession inevitable and more severe.

By the recent trends in GDP the US economy was already in recession despite a fully employed labour force. Recession without rising un-employment would have been unimaginable before the Covid lockdowns. The Fed failed to imagine the inflation that would follow the stimulus it, and the US Treasury, had provided to the post covid economy and this has become the problem for investors and speculators required to anticipate what the Fed will be doing to protect the value of the assets entrusted to them.

Yet it should be recognized that the US CPI Index in fact is no longer rising – average prices fell marginally in August as it had done the month before. But perhaps not as much as had been expected. The headline inflation rate- the rate most noticed by the households and the politicians had reached a peak of 9.1% in June and has since fallen to 8.3% as the CPI moved sideways. The increase in prices over the past three months was lower – 5.3% p.a.

Inflation in the US. Headline % p.a. Monthly % and three monthly % p.a.

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

Yet even if the average prices faced by consumers stabilized at current levels until June 2023 the headline rate of inflation would remain elevated- at 6% p.a. by year end and could return to zero only by June 2023. One wonders just how realistic are the Fed’s plans to reduce inflation rates in shorter order. Patience is called for

The outlook for Inflation if the US CPI stabilized at current levels.

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

The true surprise in the inflation print was the trend in prices that exclude volatile food and energy prices. It was these supply side shocks to prices that had helped to drive the index higher and they are reversing sharply. However, the inflation of prices, excluding food and energy remains elevated. They are now 6% ahead of price a year ago. The Fed is known to focus on core rather than headline inflation.

Headline and “Core” inflation in the US

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

The largest weight in the US CPI Index is given to the costs of Shelter. They account for over 32% of the Index of which 28% is attributed to the implied rentals owner occupiers pay to themselves. The equivalent weight in the SA CPI is much lower – 13%. Where house prices go – so do rents – and the implicit costs – rather the rewards – of home ownership – and inflation. But surely the reactions of those who own more valuable homes are very different to those who rent? Higher explicit rentals drain household budgets – and lead to less spent on other goods and services- and are resented accordingly as are all price increases. Higher implicit owner-occupied rentals do the opposite. They are welcomed and lead to more spending and borrowing. House price inflation in the US has been very rapid until recently- and rents may be catching up- meaning higher than otherwise inflation rates.

Prices always reflect a mix of demand and supply side forces. But ever higher prices- inflation – cannot perpetuate itself unless accompanied by continuous increases in demand. It is the impact of higher prices on the willingness and ability of households to spend more that is already weighing on the US economy. Incomes are barely keeping up with inflation. And the supply of money (bank deposits) and bank lending in the US has stopped growing further constrains spending. If inflation is caused by too much money chasing too few goods the US is already well on the way to permanently lower inflation. The danger is that the Fed does not recognize this in good time – and as the market place fears.

US Money Growth (M2 seasonally adjusted)

Source; Federal Reserve Bank of St.Louis, Investec Wealth and Investment

How to improve the outlook for the rand

The rand has consistently declined by more than its purchasing power parity equivalent rate against leading currencies over the years. Strong action is needed to change this.

South Africans travelling abroad should not blame the rand for their lack of purchasing power, at least not lately. In mid-January 2016, a US dollar exchanged for R16.80, a British pound then cost R24. Observers of the gyrations of the foreign exchange value of the rand should know that its exchange rate has had very little to do with the differences in inflation between SA and its trading partners. The rand has consistently bought less abroad than it has at home.

The exchange value of the rand with the US dollar or sterling has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995, when SA’s capital market was opened up, though with varying degrees of weakness. Had the rand simply followed the ratio of the SA consumer price index (CPI) to the US CPI since 1995 a dollar would now cost a mere R8. Similarly, since 1995 the difference between SA and UK inflation has been an average of 3.3% a year while the pound on average has cost an average 8.2% extra a year in rands since 1995.

Rand exchange rates against the US dollar (1995-2022)

Rand exchange rates against the US dollar chart

Source: Federal Reserve Bank of St Louis, Bloomberg and Investec Wealth & Investment, 17/08/2022

Yet not only has the rand depreciated by more than the differences in inflation over the past 27 years, it is also expected to carry on weakening by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% a year over the next 10 years and at an average 6% rate a year over the next five years. This is known as the interest carry: the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets (and to incoming tourists) this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand-denominated debt, increasing the required return on securities. Expected rand weakness sharply reduces the expected return from the RSA (government) 10-year bond to under 3% a year (10.4% nominal yield less 7.6%). This is less than the same return in US dollars offered by a US Treasury.

The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation-protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% a year for a five-year bond and 5.91% a year extra for rand investors in RSA bonds. This difference in expected inflation of 3.2% a year is significantly less than the 6% rate at which the rand is expected to weaken against the dollar over the same five years. PPP does not only not hold, but it is not expected to hold in the future. Sadly therefore, even reducing expectations of inflation may not much improve the outlook for the rand – a major issue if the cost of raising foreign or domestic capital is to be reduced.

Inflation compensation in SA and US 10-year bond markets and differences in expected inflation

Source: Bloomberg and Investec Wealth and Investment, 17/08/2022

The interest carry (difference in nominal yields) and the difference in inflation expected (2010-2022)

The interest carry (difference in nominal yields) and the difference in inflation expected chart

Source: Bloomberg and Investec Wealth and Investment, 17/08/2022

The full explanation for the exchange value of the rand is thus not to be found in the PPP rate but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA-specific risks move the ratio of the rand to other emerging market currencies about this long-term one-to-one ratio. Both the rand and the other emerging market currencies respond similarly to the same degrees of global risk tolerances that drives the US dollar stronger or weaker.

The task for SA lies in promoting capex (and so economic growth) by improving the outlook for the rand. It could do so by adopting policies that would make SA a superior emerging market attracting a much lower risk premium. SA’s recent impressive successes in the competitive businesses of international rugby and cricket, provide the case study to be emulated widely.

The exchange value of the rand vs other emerging market currencies (1996-2022)
(Higher numbers indicate rand weakness)

The exchange value of the rand vs other emerging market currencies chart

Source: Bloomberg, Investec Wealth & Investment, 17/08/2022

Reduce risk – improve growth – follow SA rugby

South Africans travelling abroad should not blame the rand for their lack of purchasing power- at least not lately. In mid-January 2016, a USD exchanged for 16.8 rands, the pound then cost R24. Observers of the gyrations of the foreign exchange value of the ZAR should know that the ZAR rate has had very little to do with differences in inflation between SA and its trading partners. The rand has consistently bought less abroad than at home.

The exchange value of the ZAR with the US dollar or UK pound has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995 when the capital market was opened up. Though with varying degrees of weakness. Had the rand simply followed the ratio of the SA CPI to the US or UK CPI since 1995 a USD would now cost a mere R8. Since 1995 the difference between SA and UK inflation has been an average 3.3% p.a. while the pound on average has cost an average 8.2% p.a. extra in rands since 1995.

Exchange rates with the US dollar. 1995-2022. Monthly Data

Source; Federal Reserve Bank of St.Louis, Bloomberg and Investec Wealth and Investment

Yet it is not merely that the ZAR has depreciated by more than differences in inflation – it is expected to continue to weaken by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% p.a. over the next 10 years and at an average 6% p.a. rate over the next five years. Known as the interest carry – these are the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets – and to incoming tourists – this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand denominated debt, increasing the required return on securities that are expected to lose their dollar value at a rapid rate. Expected rand weakness sharply reduces the expected return from the RSA 10 year bond to under 3% p.a. (10.4 nominal yield less 7.6) Less than the same return in USD offered by a US Treasury.

The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% p.a. for a five-year bond and 5.91% p.a. extra for rand investors in RSA’s. This difference in inflation expected of 3.2% p.a. is significantly less than the 6% rate at which the USD/ZAR is expected to weaken over the same five years. PPP does not only not hold- it is not expected to hold in the future. Sadly therefore even reducing inflation expected may not much improve the outlook for the ZAR- essential if the cost of raising foreign or domestic capital is to be reduced.

Inflation compensation in SA and US bond markets and differences in inflation expected

Source; Bloomberg and Investec Wealth and Investment

The interest carry (difference in nominal yields) and the difference in inflation expected. Daily data- 2010-2022.

The full explanation for the exchange value of the ZAR is to be found not in PPP but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA specific risks move the ratio ZAR/EM about this long term one to one ratio. Both the ZAR and the other EM currencies respond very similarly to the same degrees of global risk tolerances that drives the USD stronger or weaker.

The task for South Africa hoping to promote capex and so economic growth by improving the outlook for the ZAR. It could do so by adopting policies that would make SA a superior emerging market attracting a much lower risk premium. SA’s impressive success in the highly competitive business of international rugby, provides the case study – to be emulated widely.

The exchange value of the ZAR compared to other EM currencies. Higher numbers indicate rand weakness. Daily Data 1995-2022

Source; Bloomberg , Investec Wealth and Investment

More welfare- less work. An unsurprising relationship

A most extraordinary feature of the SA economy is how large a proportion of the adult population, some 58% or over 22 million of working age in early 2020, reported no income earned from employment. These estimates are abnormally high when compared to other similarly undeveloped economies. The adult population has been growing faster than the numbers employed and the participation rate in the economy has accordingly declined. A large number of South Africans including the great majority of those reporting no income, are also objectively poor. South Africa has an employment and a poverty problem. It is only when you reach the upper end of the third quintile of the income distribution that income from work becomes significant. The SA economy has served those in employment well enough in what is a dual labour market of insiders and outsiders who struggle to break in. It has failed to absorb vast numbers of potential workers into employment. A consequence but also a primary cause of slow growth.

It may be asked – how do so many survive- merely survive – with no income? The answer is mostly in the support received from the SA government or rather its taxpayers in the form of benefits in kind- education, health care, housing water and electricity and in form of cash grants for those over 60 and mothers with dependent children and for the disabled on a means or asset tested basis.

Some 50% of all government spending, currently 1.1 trillion rands, is the welfare bill of which a roughly a quarter is distributed as cash. These cash grants now include monthly payments of R350 to able bodied adults as Covid relief for which 9 million applications were made and are bound to continue indefinitely. The intention is to extend meaningfully these benefits for able bodied adults in the form of a Basic Income Grant. (BIG) The bigger the BIG in terms of benefits and coverage the more negative however will be the impact on the willingness to work of low skilled low paid workers. It will mean fewer jobs sought and provided and widen the income and cultural gaps between the fully employed skilled and, the more or less permanently, not employed.

Improved welfare benefits raise the reservation wage of all potential workers. That is the rewards required to make work a sensible choice, especially for those with limited skills or capabilities. The improved income rewards sought and realized by better welfare endowed potential workers – with limited productivity – makes them less attractive to employ. They lack the skills and training to justify higher rewards sought from understandably cost-conscious employers. Capabilities that their expensive education (provided by taxpayers) has failed to provide them with. Employers are also reluctant to stand accused of paying “starvation” wages. Who therefore prefer to employ better paid, more productive workers and hence fewer of them.

The South Africa has chosen improved welfare rather than work to relieve poverty – and has failed to do so – for want of the economic growth that would have provided a larger tax base. For which the higher tax rates needed to fund the welfare budgets are in part responsible. We should recognize the full causes of the failure to exercise our economic potential employing more workers. Ideally, with private sector involvement, we could reform education and training to deliver better qualified entrants to the labour market. And we could subsidise their employment more heavily.

Any significant increase in the tax burden to improve welfare or subsidise employment would however have to borne by formal sector workers in the form of a significant social security tax – that is a by a proportional sacrifice of their wages and salaries. There will be no other realistic place to look for additional tax revenue. It is therefore unlikely to be popular with the formally employed, the insiders whose interests, well supported by their Trade Unions, that have dominated the regulation of the demand for labour, adding further to the sacrifice of employment opportunities.